Writing a credible investment thesis

Every deal your company proposes to do-big or small, strategic
or tactical-should start with a clear statement how that particular
deal would create value for your company. We call this the
investment thesis. The investment thesis is no more or less than a
definitive statement, based on a clear understanding of how money
is made in your business, that outlines how adding this particular
business to your portfolio will make your company more valuable.
Many of the best acquirers write out their investment theses in
black and white. Joe Trustey, managing partner of private equity
and venture capital firm Summit Partners, describes the tool in one
short sentence: "It tells me why I would want to own this
business."10

Perhaps you're rolling your eyes and saying to yourself, "Well,
of course our company uses an investment thesis!" But unless you're
in the private equity business-which in our experience is more
disciplined in crafting investment theses than are corporate
buyers-the odds aren't with you. For example, our survey of 250
senior executives across all industries revealed that only 29
percent of acquiring executives started out with an investment
thesis (defined in that survey as a "sound reason for buying a
company") that stood the test of time. More than 40 percent had no
investment thesis whatsoever (!). Of those who did, fully half
discovered within three years of closing the deal that their thesis
was wrong.

Studies conducted by other firms support the conclusion that
most companies are terrifyingly unclear about why they spend their
shareholders' capital on acquisitions. A 2002 Accenture study, for
example, found that 83 percent of executives surveyed admitted they
were unable to distinguish between the value levers of M&A
deals.11 In Booz Allen Hamilton's 1999 review of thirty-four
frequent acquirers, which focused chiefly on integration,
unsuccessful acquirers admitted that they fished in uncharted
waters.12 They ranked "learning about new (and potentially related)
business areas" as a top reason for making an acquisition. (Surely
companies should know whether a business area is related to their
core before they decide to buy into it!) Successful acquirers, by
contrast, were more likely to cite "leading or responding to
industry restructuring" as a reason for making an acquisition,
suggesting that these companies had at least thought through the
strategic implications of their moves.

Not that tipping one's hat to strategy is a cure-all. In our
work with companies that are thinking about doing a deal, we often
hear that the acquisition is intended for "strategic" reasons.
That's simply not good enough. A credible investment thesis should
describe a concrete benefit, rather than a vaguely stated strategic
value.

A credible investment thesis should describe a concrete benefit,
rather than a vaguely stated strategic value.
This point needs underscoring. Justifying a deal as being
"strategic" ex post facto is, in most cases, an invitation to
inferior returns. Given how frequently we have heard weak
"strategic" justifications after a deal has closed, it's worth
passing along a warning from Craig Tall, vice chair of corporate
development and strategic planning at Washington Mutual. In recent
years, Tall's bank has made acquisitions a key part of a stunningly
successful growth record. "When I see an expensive deal," Tall told
us, "and they say it was a 'strategic' deal, it's a code for me
that somebody paid too much."13

And although sometimes the best offense is a good defense, this
axiom does not really stand in for a valid investment thesis. On
more than a few occasions, we have been witness to deals that were
initiated because an investment banker uttered the Eight Magic
Words: If you don't buy it, your competitors will.

Well, so be it. If a potential acquisition is not compelling to
you on its own merits, let it go. Let your competitors put their
good money down, and prove that their investment theses are
strong.

Let's look at a case in point: [Clear Channel Communications'
leaders Lowry, Mark, and Randall] Mayses' decision to move from
radios into outdoor advertising (billboards, to most of us). Based
on our conversations with Randall Mays, we summarize their
investment thesis for buying into the billboard business as
follows:

Clear Channel's expansion into outdoor advertising leverages the
company's core competencies in two ways: First, the local market
sales force that is already in place to sell radio ads can now sell
outdoor ads to many of the same buyers, and Clear Channel is
uniquely positioned to sell both local and national advertisements.
Second, similar to the radio industry twenty years ago, the outdoor
advertising industry is fragmented and undercapitalized. Clear
Channel has the capital needed to "roll up" a significant fraction
of this industry, as well as the cash flow and management systems
needed to reduce operating expenses across a consolidated
business.

Note that in Clear Channel's investment thesis (at least as
we've stated it), the benefits would be derived from three
sources:

Leveraging an existing sales force more extensively
Using the balance sheet to roll up and fund an undercapitalized
business
Applying operating skills learned in the radio trade
Note also the emphasis on tangible and quantifiable results, which
can be easily communicated and tested. All stakeholders, including
investors, employees, debtors, and vendors, should understand why a
deal will make their company stronger. Does the investment thesis
make sense only to those who know the company best? If so, that's
probably a bad sign. Is senior management arguing that a deal's
inherent genius is too complex to be understood by all
stakeholders, or simply asserting that the deal is "strategic"?
These, too, are probably bad signs.

Most of the best acquirers we've studied try to get the thesis
down on paper as soon as possible. Getting it down in black and
white-wrapping specific words around the ideas-allows them to
circulate the thesis internally and to generate reactions early and
often.

The perils of the "transformational" deal. Some readers may be
wondering whether there isn't a less tangible, but equally
credible, rationale for an investment thesis: the transformational
deal. Such transactions, which became popular in the exuberant
'90s, aim to turn companies (and sometimes even whole industries)
on their head and "transform" them. In effect, they change a
company's basis of competition through a dramatic redeployment of
assets.

The roster of companies that have favored transformational deals
includes Vivendi Universal, AOL Time Warner (which changed its name
back to Time Warner in October 2003), Enron, Williams, and others.
Perhaps that list alone is enough to turn our readers off the
concept of the transformational deal. (We admit it: We keep wanting
to put that word transformational in quotes.) But let's dig a
little deeper.

Sometimes what looks like a successful transformational deal is
really a case of mistaken identity. In search of effective
transformations, people sometimes cite the examples of DuPont-which
after World War I used M&A to transform itself from a maker of
explosives into a broad-based leader in the chemicals industry-and
General Motors, which, through the consolidation of several car
companies, transformed the auto industry. But when you actually
dissect the moves of such industry winners, you find that they
worked their way down the same learning curve as the best-practice
companies in our global study. GM never attempted the
transformational deal; instead, it rolled up smaller car companies
until it had the scale to take on a Ford-and win. DuPont was
similarly patient; it broadened its product scope into a range of
chemistry-based industries, acquisition by acquisition.

In a more recent example, Rexam PLC has transformed itself from
a broad-based conglomerate into a global leader in packaging by
actively managing its portfolio and growing its core business.
Beginning in the late '90s, Rexam shed diverse businesses in
cyclical industries and grew scale in cans. First it acquired
Europe's largest beverage-can manufacturer, Sweden's PLM, in 1999.
Then it bought U.S.-based packager American National Can in 2000,
making itself the largest beverage-can maker in the world. In other
words, Rexam acquired with a clear investment thesis in mind: to
grow scale in can making or broaden geographic scope. The
collective impact of these many small steps was
transformation.14

But what of the literal transformational deal? You saw the
preceding list of companies. Our advice is unequivocal: Stay out of
this high-stakes game. Recent efforts to transform companies via
the megadeal have failed or faltered. The glamour is blinding,
which only makes the route more treacherous and the destination
less clear. If you go this route, you are very likely to destroy
value for your shareholders.

By definition, the transformational deal can't have a clear
investment thesis, and evidence from the movement of stock prices
immediately following deal announcements suggests that the market
prefers deals that have a clear investment thesis. In "Deals That
Create Value," for example, McKinsey scrutinized stock price
movements before and after 231 corporate transactions over a
five-year period.15 The study concluded that the market prefers
"expansionist" deals, in which a company "seeks to boost its market
share by consolidating, by moving into new geographic regions, or
by adding new distribution channels for existing products and
services."

On average, McKinsey reported, deals of the "expansionist"
variety earned a stock market premium in the days following their
announcement. By contrast, "transformative" deals-whereby companies
threw themselves bodily into a new line of business-destroyed an
average of 5.3 percent of market value immediately after the deal's
announcement. Translating these findings into our own
terminology:

Expansionist deals are more likely to have a clear investment
thesis, while "transformative" deals often have no credible
rationale.
The market is likely to reward the former and punish the
latter.
The dilution/accretion debate. One more side discussion that comes
to bear on the investment thesis: Deal making is often driven by
what we'll call the dilution/accretion debate. We will argue that
this debate must be taken into account as you develop your
investment thesis, but your thesis making should not be driven by
this debate.

Sometimes what looks like a successful transformational deal is
really a case of mistaken identity.
Simply put, a deal is dilutive if it causes the acquiring company
to have lower earnings per share (EPS) than it had before the
transaction. As they teach in Finance 101, this happens when the
asset return on the purchased business is less than the cost of the
debt or equity (e.g., through the issuance of new shares) needed to
pay for the deal. Dilution can also occur when an asset is sold,
because the earnings power of the business being sold is greater
than the return on the alternative use of the proceeds (e.g.,
paying down debt, redeeming shares, or buying something else). An
accretive deal, of course, has the opposite outcomes.

But that's only the first of two shoes that may drop. The second
shoe is, How will Wall Street respond? Will investors punish the
company (or reward it) for its dilutive ways?

Aware of this two-shoes-dropping phenomenon, many CEOs and CFOs
use the litmus test of earnings accretion/dilution as the first
hurdle that should be put in front of every proposed deal. One of
these skilled acquirers is Citigroup's [former] CFO Todd Thomson,
who told us:

It's an incredibly powerful discipline to put in place a rule of
thumb that deals have to be accretive within some [specific] period
of time. At Citigroup, my rule of thumb is it has to be accretive
within the first twelve months, in terms of EPS, and it has to
reach our capital rate of return, which is over 20 percent return
within three to four years. And it has to make sense both
financially and strategically, which means it has to have at least
as fast a growth rate as we expect from our businesses in general,
which is 10 to 15 percent a year.

Now, not all of our deals meet that hurdle. But if I set that up
to begin with, then if [a deal is] not going to meet that hurdle,
people know they better make a heck of a compelling argument about
why it doesn't have to be accretive in year one, or why it may take
year four or five or six to be able to hit that return level.16

Unfortunately, dilution is a problem that has to be wrestled
with on a regular basis. As Mike Bertasso, the head of H. J.
Heinz's Asia-Pacific businesses, told us, "If a business is
accretive, it is probably low-growth and cheap for a reason. If it
is dilutive, it's probably high-growth and attractive, and we can't
afford it."17 Even if you can't afford them, steering clear of
dilutive deals seems sensible enough, on the face of it. Why would
a company's leaders ever knowingly take steps that would decrease
their EPS?

The answer, of course, is to invest for the future. As part of
the research leading up to this book, Bain looked at a hundred
deals that involved EPS accretion and dilution. All the deals were
large enough and public enough to have had an effect on the buyer's
stock price. The result was surprising: First-year accretion and
dilution did not matter to shareholders. In other words, there was
no statistical correlation between future stock performance and
whether the company did an accretive or dilutive deal. If anything,
the dilutive deals slightly outperformed. Why? Because dilutive
deals are almost always involved in buying higher-growth assets,
and therefore by their nature pass Thomson's test of a "heck of a
compelling argument."

As a rule, investors like to see their companies investing in
growth. We believe that investors in the stock market do, in fact,
look past reported EPS numbers in an effort to understand how the
investment thesis will improve the business they already own. If
the investment thesis holds up to this kind of scrutiny, then some
short-term dilution is probably acceptable.

Reprinted with permission of Harvard Business School Press.
Mastering the Merger: Four Critical Decisions That Make or Break
the Deal, by David Harding and Sam Rovit. Copyright 2004 Bain &
Company; All Rights Reserved.

[ Buy this book ]

David Harding (HBS MBA '84) is a director in Bain &
Company's Boston office and is an expert in corporate strategy and
organizational effectiveness.

Sam Rovit (HBS MBA '89) is a director in the Chicago office and
leader of Bain & Company's Global Mergers and Acquisitions
Practice.

Footnotes:

10. Joe Trustey, telephone interview by David Harding, Bain
& Company. Boston: 13 May 2003. Subsequent comments by Trustey
are also from this interview.